Eli Lilly's Survival Plan Is Far from Generic

Eli Lilly CEO John Lechleiter has become the holdout kid. Unlike his chief rivals, he vows the 134-year-old drugmaker will strike no mega-deals as its top medicines face a seeming Apocalypse of patent expirations.

Grappling with a similar onslaught of generics, Pfizer and Merck last year purchased Wyeth and Schering-Plough, respectively. By doing so, they acquired new products, the promise of huge cost savings from laying off redundant staff, and potential stable earnings. They also bought themselves temporary peace of mind.

The companies had previously denounced big mergers as a sure way to destroy drug innovation, but could not resist the considerable short-term advantages of doing a deal.

Lechleiter isn't having any of it. He scorns the very thought of a big merger or major acquisition to cushion the patent blows, even though drugstores will be flooded between now and 2014 with generic forms of Lilly's Gemzar cancer drug, Zyprexa schizophrenia treatment,

A 31-year Lilly veteran who began as a chemist, Lechleiter says big pharmaceutical mergers invariably fail because they kill innovation and productivity. Lilly points to Pfizer Inc., whose laboratories have failed to produce any big-selling medicines in the past decade despite several huge mergers.

Instead, Lechleiter is determined to go it alone. He is counting on Lilly's own crop of experimental drugs to pass clinical trials and be approved in time to resurrect profit growth after the painful period of patent lapses, which Lilly has nicknamed "the YZ years."

"We now have nearly 70 molecules in clinical stage development, and others behind the curtain that are not yet in human testing," Lechleiter told Reuters in an interview at company headquarters. "While all of those won't make it, many of them will and many will be valuable products and ultimately drive shareholder growth. That is why people invest in our industry."

That said, some people who do invest in the industry find his unflagging optimism a bit baffling. After all, when it comes to getting new products to market, Lilly and other drugmakers have had a long losing streak.

"It's a very strange position they're taking, considering what they're facing," said Standard and Poor's analyst Herman Saftlas. "They have to do something, or the patent cliff will kill them. How are they going to support their dividend?"

Saftlas believes that Lechleiter's approach may reflect Lilly's U.S. heartland roots — for better or worse. "It seems to be a very stoic approach, a very rigid mind-set that is very different from what we've seen in New York and New Jersey. There is that type of mentality in the Midwest, of sticking to your guns and toughing it out," he said.

The consensus view is that it will be tough to weather the patent storm without a big deal to broaden its product lineup and its pipeline of experimental drugs that has been buffeted by failures this year.

Industry analysts fear that Indianapolis — home to Lilly and 11,000 of its employees — could also pay dearly for the company's no-merger strategy. That is, if it doesn't work, and Lechleiter refuses to believe it won't.

LILLY FIELDS

The third largest city in the Midwestern United States, with a population of 800,000, Indianapolis fell into decay in the 1970s and 1980s. But it has made an impressive rebound in recent years, with a new airport terminal, a new home for the Indianapolis Colts football team, Lucas Oil Stadium, and a major ongoing expansion of its convention center and hotels.

Its central location and crisscross of interstate highways — putting the city within a day's drive of half the nation's population — are a major calling card. In good times and bad, Lilly has always been a bastion of stability. But now the drugmaker's own good health, and survival, are very much at risk.

To prepare for the coming flood of generics, Lilly a year ago said it would cut 5,500 workers, or nearly 14 percent of its global workforce, by 2011 to save $1 billion annually. Many of the cuts are hitting Lilly's sprawling corporate headquarters, labs and manufacturing plants in Indiana's capital city.

The office vacancy rate in downtown Indianapolis has jumped to more than 20 percent, up from 17.8 percent several months earlier, as a result of Lilly moving out of two large buildings near its main headquarters, according to the Indianapolis Star.

The current round of job cuts is only half over, and some analysts expect new rounds to come as the generics arrive and devastate its leading brands.

BRACING FOR PROFIT HIT

Lechleiter expects annual company sales to be above $20 billion in 2014, which he calls the "trough year" of the patent crisis. That would be roughly in line with 2009 revenue, helped by sales growth of medicines not facing generic competition, as well as an expected doubling of sales by then in emerging markets and of the company's animal health business.

The outlook for profits is far more sobering, if not frightening. Lechleiter expects annual net profit, now in the $5 billion range, to retreat to somewhat more than $3 billion in 2014. That means earnings could tumble as much as 40 percent, as higher taxes and a higher percentage of older drugs crimp profit margins.

Yet, with Zen-like composure, Lechleiter says Lilly will take the earnings hit and then rebuild from there. "Whenever the base is established, that's going to be the set point for the growth that hopefully follows, based on the launch of these products we now have in our portfolio. The key is launching new medicines."

Importantly, Lilly expects annual cash flow of more than $4 billion, which it considers adequate to guarantee that its generous dividend — the candy that keeps many Lilly investors on board — remains intact through the YZ years.

"Our appetite for doing deals is going to be guided or tempered by the financial constraints we've placed on ourselves to maintain our dividend at least at its current rate," Lechleiter said.

To Sam Isaly, managing partner of healthcare investment firm OrbiMed Advisors, Lilly has almost a mystical faith that its drug pipeline will save the day, but without good reason.

"Those guys have their heads in the sand — deep, real deep in the sand — when you consider their productivity has been close to zero," Isaly said.

Although Lilly a decade ago launched the wave of medicines now facing patent expirations, it has had an "abysmal" record since Cymbalta was approved in 2004, according to Isaly. "They haven't introduced anything from their own labs since then," he said.

Lilly did in fact launch two medicines discovered by other drugmakers during that time. They are Byetta, a diabetes medicine sold in partnership with Amylin Pharmaceuticals Inc, and Effient, a blood clot preventer partnered with Daiichi Sankyo. Effient — which Lilly had billed as a potential blockbuster when it was approved 16 months ago — has won little notice and middling sales.

Although Lilly garners annual revenue of about $400 million from Byetta, the drug's sales have not lived up to Wall Street expectations. Making matters worse, the U.S. Food and Drug Administration last month rejected a long-acting form of Byetta called Bydureon — the most important drug in Lilly's pipeline. Regulators demanded heart-safety data on the once-weekly product, which could delay its launch for two years, or even threaten its approval.

Cowen and Co. has been counting on Bydureon and Byetta to post combined annual sales of almost $3 billion by 2015, helping Lilly weather its patent cliff. But the Bydureon delay could now allow Novo Nordisk's recently approved Victoza, a similar treatment to Byetta, to capture a greater foothold.

A day after the Bydureon rejection, late-stage trials of Lilly's experimental diabetes drug teplizumab — which held promise of $500 million in annual sales — were halted early after it was deemed ineffective.

Other setbacks have piled up. In August Lilly scrapped one of its two treatments in late-stage studies for Alzheimer's disease, called semagacestat, after it was deemed ineffective. And federal judges since late July have shot down patents on its cancer drug Gemzar and its Strattera treatment for attention deficit disorder.

Gemzar, with annual sales of $1.25 billion, could face U.S. generics within days. Strattera, having sales of more than $500 million, could soon suffer the same fate if Lilly loses its ongoing appeal of the patent decision.

In spite of Lilly's inability to get many of its drugs off the ground, Lechleiter has told investors the company plans to have 10 drugs in late-stage studies by the end of next year. He also said the company intends to introduce two new prescription medicines a year, beginning in 2013.

POSTURING, OR GIVING HOPE TO TROOPS?

Despite skepticism among some investors, Jan Lundberg, Lilly's research chief, insists there is far better hope for the company if it remains independent. He said embracing a big merger could throw his scientists and research laboratories out of whack.

"Mergers in the pharma world are more a matter of reducing costs, and do not help productivity," Lundberg said in an interview. "Scientists become distracted about whether they have a future role, so they'd rather do the safe, me-too, thing than the risky, inventive thing because you don't want to take risks with new bosses. It's not easy to innovate under the gallows."

Lundberg said the company's most promising experimental drugs are potential treatments for Alzheimer's disease, cancer, diabetes and autoimmune diseases such as rheumatoid arthritis and multiple sclerosis.

Although semagacestat failed to help Alzheimer's patients, Lundberg said another drug in late-stage trials against the degenerative brain disease, called solanezumab, holds promise. "If the company succeeds in this area it will have a huge financial return."

Lilly's oncology pipeline is on par "with the biggest in the industry," Lundberg said, with four cancer drugs in Phase III trials. They include two biotech medicines acquired in the ImClone deal, ramucirumab (formerly known as IMC-1121B) for stomach and breast cancers, and necitumumab (formerly IMC-11F8) for lung cancer. Two other compounds are in late-stage trials for melanoma and lymphoma.

A pair of medicines is in late-stage trials for diabetes, including one designed to calm immune system response among patients with the inherited Type 1 form of the disease. The other medicine, nicknamed GLP-Fc, is similar to Bydureon. But Lilly owns it outright and would not have to share revenue with a partner.

"The autoimmune area is new for Lilly," Lundberg said, noting the company has bets on three drugs in mid-stage trials. One is a high-profile compound for rheumatoid arthritis that blocks a protein called BAFF.

"This could be the next-generation treatment" for the debilitating joint disease, he said, and help the high percentage of patients that do not benefit over time with leading biotech drugs, such as Abbott Laboratories Inc.'s Humira and Johnson & Johnson's Remicade.

Building on the company's longtime strength in psychiatry, Lilly is also testing new classes of medicines for depression and schizophrenia.
Several other drugs in earlier-stage trials could be "sleepers," Lundberg said, with significant sales potential if they clear coming hurdles.

He said they include medicines to speed healing of bone fractures and to build muscle strength in the elderly. "Hip fracture in the elderly is a very severe condition and many patients never get mobilized again. It's a potentially big market."

In the meantime, Lilly continues to hunt for relatively small deals, to license or buy new products to expand its pipeline. The company, which has a market capitalization of about $41 billion, has focused on transactions in the $1 billion range, although two years ago it paid $6.5 billion for ImClone Systems and its Erbitux cancer drug — its biggest deal ever. Its second largest deal was the $2.3 billion purchase of biotech ICOS Corp. in 2007, giving Lilly full ownership of their shared Cialis anti-impotence drug.

"Now Lilly has to ponder something a whole lot bigger," Isaly said.

"They might have to shell out $20 billion or more to find the assets to tide them over."

Isaly said biotechs with important products, such as Genzyme Corp. — which French drugmaker Sanofi-Aventis is pursuing to cushion its own patent struggles — is the kind and size of deal that might make sense for Lilly.

But Derica Rice, Lilly's chief financial officer, suggested such costly deals were not in the offing. "Look at the history of Lilly. The largest deal we've ever done is ImClone, for $6.5 billion, and the next largest was $2 billion," said Rice. "Everything else has been smaller. If investors began to see actions from Lilly that are counter to that, they'd begin to question whether management has changed its strategy, and we have not."

Lilly remains focused, he said, on buying small companies, or licensing their drugs, which are in later stages of human trials or nearing approval, and which complement its own roster of medicines.

For example, he noted that Lilly recently licensed rights to a statin cholesterol fighter, called Livalo, from privately held Kowa Co. Ltd. of Japan, and has licensed an underarm testosterone gel called Axiron from Australian drugmaker Acrux Ltd. In another recent deal, valued at up to $755 million, Lilly bought global rights to Incyte Corp.'s oral JAK1/JAK2 inhibitor to treat rheumatoid arthritis.

"It's clear we're not pursuing large-scale mergers similar to our peers," said Rice. "We're not chasing windmills. We have a strategy and that's our roadmap, our guidepost. And as you go through turbulent times where there are a lot of potential distractions and noise, discipline and focus will help us execute."

The coming generic challenge will eclipse in importance Lilly's unexpected loss of patent protection in 2001 on Prozac, its flagship drug. The anti-depressant, with annual U.S. sales of $2.4 billion, accounted for some 30 percent of the company's revenue.

Then, as now, Lilly vowed it would not pursue a big merger to smooth out its earnings. And it kept that promise, helped by a half dozen experimental medicines that were launched in rapid succession and became its biggest brands — the lineup now facing patent expirations.

Rival drugmakers have also slashed their workforces, and seen their share prices stagnate due to their own approaching confrontations with generics. Like Lilly, they have been unable to launch many big-selling new drugs in recent years due to failed clinical trials and tougher scrutiny by the U.S. Food and Drug Administration. But Wall Street has meted out more punishment to Lilly.

Its shares have fallen 37 percent in the past three years, compared with a 12 percent decline for the ARCA Pharmaceutical Index of large U.S. and European drugmakers.

BOTTOM OF PILE, BUT MORE ROOM TO FALL

"The value of the industry has been decimated, and Lilly is perhaps at the bottom of the pile," said Viren Mehta, of Mehta Partners, a pharmaceuticals advisory group. "As with the industry, the question is how much lower Lilly's valuation can go."

Lilly has held on to many investors with the highest dividend among U.S. rivals, offering an annual yield of 5.5 percent. Company shares trade at 7.5 times 2011 per share earnings, lower than any of its U.S. rivals, another reflection of Lilly's perceived weak prospects.

But by another measure, Lilly shares are far from cheap. They are trading at a multiple of 12.5 times projected per share earnings in 2014, when the company's cumulative injury from generics will be at its worst, a significant premium to its rivals. That suggests Lilly shares have ample room to drop, especially if more of its experimental products fall by the wayside.

For the moment, Mehta said no larger rivals appear to be circling Lilly because most are going through their own misery. Lilly could become attractive as a takeover target, however, and subject more of its own workforce to the chopping block if its shares keep shedding value, Mehta said.

Still, he and other critics agree that mega-mergers are no silver bullet. Almost every one of them in recent decades have failed, meaning their flow of important new drugs was stymied by cultural clashes or loss of focus as the companies combined operations, Mehta said.

"So you can't excessively criticize Lilly's stance against mega-mergers because there's strong evidence they typically don't create value. But if someone was willing to pay a sufficient premium, then Lilly would have no option but to accept it."

In the meantime, Mehta said most investors have already abandoned Lilly. "Those left are hoping either for a take out in the short term, or, like John Lechleiter, biding their time in hopes something works out."

Disbelievers predominate, with 20 of 22 analysts polled by Thomson Reuters having a "hold," "underperform" or "sell" rating on Lilly. By contrast, half of analysts have "buy" or "strong buy" ratings for Bristol-Myers Squibb Co., whose patent expirations through 2013 will be almost as severe as Lilly's.

But unlike Lilly, its New York rival has a pipeline bursting with medicines that have performed well in clinical trials, including potential blockbuster treatments for melanoma and blood clots that could rejuvenate company sales and earnings fairly quickly.

Lilly has its defenders, however. One of them is Avik Roy, a healthcare analyst for New York brokerage Monness, Crespi, Hardt & Co. He said the company should be praised for staunchly resisting Wall Street clamors for a big merger.

"John Lechleiter is showing intellectual courage by being willing to suck up and take the punch of the approaching earnings decline, while recognizing the long term value of the company will be driven by internal research and development productivity," Roy said.

Like others, he is skeptical of the gains from mega-mergers. "The problem with big mergers is that the R&D guys from Company A are thrown together with those from Company B and the guy with the most pull with senior management keeps his drugs and his guys on board, while the other guy gets let go," he said. "It's not meritocratic; it's political. It's rarely a rational process and there's a five-year period of stagnation because of all the politics in these big mergers."

By swearing off a major deal, Roy said Lechleiter might be making a personal financial sacrifice as well. CEOs typically win big bonuses, equity options and other incentive pay once such deals start temporarily turbocharging earnings.

An extreme example was former Pfizer CEO Hank McKinnell, who helped spearhead back-to-back mergers with Warner-Lambert and Pharmacia in 2000 and 2003, respectively. Pfizer pushed him out in 2006 after huge cost savings from the mergers finally evaporated and the bloated company languished. Despite his failed tenure, McKinnell walked away with more than $200 million in retirement pay and other compensation.

"When you're willing to say, 'However I'm paid, I'm more interested in the long-term growth of the company than merging with someone else,' that's an approach people should approve," Roy said.

For that reason, some believe Lilly's stock may prove to be a worthy gamble. Michael Liss, portfolio manager of the American Century Value Fund said Lilly is worth holding for a year or two to see how its pipeline fares or whether a rival goes gunning for the drugmaker. In either case, he thinks investors stand to profit.

"Lilly's pipeline has been very disappointing, but eventually I think their drugs will be approved and become a commercial success," said Liss.

By his calculations, the company's current share price assumes no value for any of its experimental medicines. "In fact there's almost a negative value being assigned for their R&D," Liss said. "People are extrapolating from the last couple of years that none of their new drugs are going to get passed. But I'm willing to bet they will have at least a few successes."

If it doesn't, he also predicted Lilly will become a takeover target.

"Someone will find them attractive for the drugs they do have, and for cost cuts after buying them. And Lilly would have to do its fiduciary duty, and explore the possibility of selling themselves." He thinks Lilly can hold out "a couple of more years" before its hand is forced.

SHADES OF KALAMAZOO

The potential impact of a takeover, hostile or otherwise, may not have yet fully dawned on Indianapolis. If circumstances tilt in that direction, memories may turn to 1995 and the city of Kalamazoo, Michigan. The Midwestern city never recovered from the takeover that year of hometown drugmaker Upjohn by Swedish drugmaker Pharmacia AB and the resulting job cuts.

Upjohn, overwhelmed by generic competition, sold itself for $6 billion and the combined company, Pharmacia & Upjohn, became headquartered in London. Two years later, Pharmacia & Upjohn relocated to New Jersey and pulled its North American sales and marketing teams out of Kalamazoo. In 2000, the company merged with Monsanto Co, only to be gobbled up in 2003 by New York-based Pfizer, which eliminated 20 percent of the remaining Pharmacia and Upjohn employees in Western Michigan.

Lilly's paychecks, purchases, civic improvements and cultural largesse have kept Indiana's capital city humming for generations, while also enriching the Hoosier State. A study by Indiana University calculates the drugmaker contributes more than $8 billion a year to the state economy.

"Lilly is like a cherished uncle in the family," said Roland Dorson, president of the Indianapolis Chamber of Commerce. "They provide not only thousands of jobs, but they have a heritage, a legacy, of giving back, and they are deeply, deeply involved in the community."

The drugmaker makes a point of buying from local suppliers and vendors, just one example of its civic engagement and its importance to the local economy.

"Certainly, Lilly has a strong culture and perhaps some of that is driving their philosophy not to pursue big mergers, because that could lead to a culture clash," said Peter Jankovskis, co-chief investment officer of Oak Brook Investments. "Being a company town, Lilly has their own way of doing things and there is always the danger a big merger partner will have a different mind-set and way of doing things. That sometimes makes mergers fail."

The company's civic consciousness goes back to Colonel Eli Lilly, a chemist and Civil War veteran who founded the drugmaker in 1876. He championed the building of roads, bridges and parks and lavished the fast-growing city with his philanthropy.

Family members remained active in the company until recent decades, but no longer are involved in management. The Lilly Endowment, a private family foundation established in 1937 by three of Lilly's heirs, has awarded more than $7 billion in grants over the years, largely to Indiana organizations.

Although the endowment is the drugmaker's biggest stockholder, holding more than 11 percent of Lilly's shares, it is not represented on Lilly's board of directors and declined to comment on company strategy.

"More than 90 percent of our assets are in the company, although we are separate from the company," said endowment spokeswoman Gretchen Wolfram. "We vote our shares like any other common shareholder."

The drugmaker, likewise, has its own multitude of philanthropies, separate from the endowment. "Eli Lilly is a huge supporter of the symphony and everything in town basically," Wolfram said.

Just last month, on Oct. 7 from daybreak to sunset, more than 8,000 of Lilly's employees were freed from their desks and centrifuges to beautify an industrial corridor of Interstate 70, from the new airport terminal to downtown.

Using shovels, trowels and rakes, they planted 1,600 trees and 72,000 native plants and shrubs.

"It will all look magnificent in the spring, when everything blooms," Dorson said of the formerly barren stretch of Interstate.

How delightful Lilly will look next year, as its generic crisis unfolds, is another question.